I have a BA in Natural Sciences and Mathematics and am currently working towards a Certificate of Finance from TESU. (Only 3 credits to go!)
In Section I, we talked about how mutual funds are (essentially) a big pool of money created by the contributions of many, many investors like you and me.
"But, Earl!" you ask, "Who decides where to invest all of that money??"
Decisions about how the money in a fund is invested are made by mutual fund manager(s). In this way, folks who are eager to share in the historic returns enjoyed by the stock market — but have no desire to wade neck-deep into the why and how of Wall Street operations (Technical stock analysis, market trends, interest and inflation rates, oh my!) — can leverage the knowledge of professional financiers whose job it is to make their investors’ money earn money. Essentially, once a person has invested a principal amount into a mutual fund, all of the hard work involved with earning returns on that capital (through the buying and selling of various financial securities like stocks and bonds) is handled by someone else! Let me take a moment to clarify, though, lest you begin to form an image in your mind of autocratic fund managers, who wield absolute power over how your hard-earned money is invested:
There are specific guidelines that managers must adhere to when buying and selling securities that largely depend on a fund’s market strategy. As such, investors are able to maintain a measure of control over how their money is invested, by
purchasing shares of mutual funds that are in keeping with their investment style, risk tolerance and financial goals (more on determining an investment plan that is right for you in Section IV.).
But, what are the different kinds of funds?
Mutual funds can generally be classified as fitting into one of four categories:
- Stock Funds
- Bond Funds
- Hybrid Funds
- Money Market Funds
While some funds will mix and match between their primary specializations — according to the overall investment strategy detailed in the fund’s prospectus (an informational package provided by parent companies that describes everything you wanted to know about a specific mutual fund) — these classifications will give you a basic idea of what kinds of funds are available. Within the parent groupings of stock and bond funds, there also exist sub-categories which I will detail below. Hybrid funds generally combine the traits of two or more different kinds of funds (usually stock and bond), but if you understand stock and bond funds, then you can easily grasp the concept of hybrids. Money market funds, discussed last, are the most straightforward.
Mutual funds that invest capital in the companies that make up the stock market are (conveniently) called stock funds. What this means is that all of the money that investors have pooled together for a fund of this type will be invested in stocks — from whichever companies the fund manager(s) think will produce the best returns for investors — within the market sectors that the fund specializes in. (i.e., If a
fund focuses on large companies located within the U.S., then its manager(s) will seek to acquire stocks from whichever companies meeting that geographic restriction that they think are poised to do well. Contrarily, if a fund focuses on foreign companies, then most — if not all — of the stock holdings for the fund will be with companies located in countries outside of the U.S.)
Furthermore, stock — sometimes called equity — funds may be divided into the sub-categories of growth or value funds. Growth funds are comprised of stocks from companies with a high share price in relation to their assets, and are therefore considered to be more volatile. On the other hand, value funds are made up of stocks that are priced cheaply compared to company assets, and are expected to experience less in the way of volatility. Essentially, growth funds are riskier but have a higher potential for return, and value funds are more secure but less likely to experience the rapid gains that growth funds are poised to make (under favorable market conditions).
Market-capitalization (or "cap") refers to the size of a stock issuing company. It is the price per share multiplied by total shares outstanding. The most common (arbitrary) designations that you are likely to hear, are: Small-cap (less than two billion dollars);
Medium-cap (greater than two billion but less than ten billion dollars); Large-cap (greater than ten billion dollars)
It is usually a good idea to spread your stock mutual fund holdings out over several funds that focus on different market sectors. For example, if you divide the money that you have earmarked for stock fund investment into fourths, then one fourth of the money could go into a fund that focuses on small U.S. companies. Another fourth will be used to purchase a fund that specializes in medium-sized U.S.
companies. Yet another fourth gets put into a fund that invests in large U.S. companies, and the last fourth goes into a fund that invests internationally. In this way, your stock mutual fund portfolio can be reasonably diversified across the market, while simultaneously positioning you to earn the returns that have historically been observed in the overall stock market (about 10% per year, remember?). You are merely protected if one or more sectors fair badly in a down market.
Alternatively, you could invest seventy-five percent of the capital that you have earmarked for stock securities in a mutual fund that follows the overall U.S. market — such as Vanguard’s Total Stock Market Index (ticker symbol: VTSMX) — and twenty-five percent in an international fund, such as Oakmark’s Oakmark International I (OAKIX), and you will have achieved a comparable level of diversification in your portfolio to the previous example. Also, there is nothing to stop you from investing three-fourths of your investment capital internationally, and one-fourth domestically! There are no rules set in stone for diversifying your stock mutual fund portfolio, although it is good practice to invest so that the separate
slices of your investment pie combine to form a complete picture of the entire market.
(See Section VII. for a list of highly respected mutual funds, arranged by family and market categorization.)
In any event, an important consideration when choosing which funds to invest in are the fund’s total operating expenses, which are discussed in detail in Section III. For now, just know that the variety of stock funds that have the lowest expenses are known as index funds. Moreover, index funds such as Vanguard’s famous S&P 500 Index Fund (ticker symbol: VFINX) usually outperform around seventy-five
percent of their actively traded, “non-index fund” brethren. When you are finally ready to begin purchasing mutual funds (hopefully, after reading this tutorial), it is strongly recommended that you purchase funds of the index variety.
Index Funds like Vanguard’s S&P 500 Index (ticker symbol: VFINX) keep expenses low by buying and holding, minimizing trading, and passively mirroring the benchmark that they follow, rather than by trying to “actively” beat the market. The proof is in the pudding with index funds, as they have historically outperformed about seventy-five percent of actively traded funds!
For ultra-conservative investors (*Yawn!*), some bond funds are usually considered to be a safer alternative to stock funds. The drawback is that the most reliable bond funds don’t earn anywhere near the returns that stock funds do! However, there is something to be said for piece-of-mind, and if you are willing to sacrifice earning larger returns on your investments in order to avoid the dramatic fluctuations that the stock market has been known to experience every once in a while, then you may want to place more of your holdings into some solid conservative bond funds (see Section IV. to learn an easy formula for calculating your recommended investment allocation, based on age and risk tolerance).
Bond funds can be classified into three general categories: short-term; intermediate-term; long-term. Short-term bond funds are the least volatile, and are generally considered to be “safest.” Naturally, these conservative short-term bond funds also earn the smallest returns. Long-term bond funds are at the other end of the spectrum, and are by far the most “risky” members of the bond fund family. These funds enjoy more in the way of potential returns, due to this added risk. Intermediate-term bond funds, as you have probably already deduced, fall in between the two extremes.
Investing in bond funds can get complicated in a hurry. First, you must make the decision to invest in funds that pay higher — but taxable — yields, or tax-free funds that pay lower yields. Moreover, the sales and marketing divisions of some unscrupulous funds have been known to misrepresent earnings reports in order to make a fund seem more attractive to potential investors. This is done by sinking
capital into risky companies, “temporarily” waiving expense ratios, inflating yields by feeding principals (the amount you originally invested) back to shareholders at the expense of long-term returns, as well as a host of other misleading practices.
For the novice investor, it is of the utmost importance to only deal with the most reputable of bond fund providers, in order to avoid the tricks and traps employed by unethical financiers. Furthermore, it doesn’t matter if you invest in bond funds with taxable yields if you invest through a retirement account! (I explain the benefits of investing through tax-sheltered retirement accounts in Section V.) Table 3 below
provides a glimpse at the average net returns for an initial principal of $10,000, as if invested in three term-different bond funds, from 2003 – 2013. You’ll see the Vanguard funds that were used for this table again in Section VII, when I list a few highly respected mutual funds that you may want to consider when you are ready to invest.
TABLE 3: Comparison of a $10,000 Principal, as if Invested in Three Term-Different Vanguard Bond Funds, Over a Period of Ten Years
|SHORT-TERM (VFSTX)||INTERMEDIATE-TERM (VFIIX)||LONG-TERM (VWESX|
Money Market Funds
Money Market Funds are really just glorified checking accounts! They are used by investors primarily as a place to stash emergency capital (e.g., for use in times of unexpected hardship caused from something like unemployment or losing a job or a fire resulting in property loss, an impatient bookie to whom you owe money … you get the idea) or as a place to park money awaiting investment. Each share in a money market fund is worth one dollar. When an investor decides which securities he or she would like to purchase, these money market shares — of one dollar apiece — are swapped out (electronically) for cash in order to buy those securities. The upswing to money market funds over most checking and savings accounts is that your money earns a higher rate of interest.
These funds are a great place to park some spare cash in case of emergencies, or to set aside funds for an upcoming purchase (e.g., a new home, your kid’s braces, a motorcycle). In fact, money market accounts may even be used as a part of your investment strategy. For example, if you have your eye on an attractive security, but notice that it’s currently overpriced (see the next section to learn how to determine if an investment security is overpriced), you can place the funds in a money market account while you wait for prices to even out.
Some folks are wary about placing their savings in money market accounts, because they suspect these funds of being somehow related to all of that “risky stock market business.” In fact, thanks to federal regulations, money market funds are only allowed to invest in securities with the highest credit ratings, and their holdings must have an average term maturity of no more than 90 days. Also, did you know that large banks are only required to keep ten cents on the dollar in-house for every dollar that you entrust to them for safekeeping? Moderately sized banks are only required to keep three cents on the dollar available, and some smaller banks aren’t required to hold anything in reserve! On the other hand, it should comfort you to know that every dollar you invest in mutual funds — whether they be stock, bond, hybrid, or money market — corresponds proportionately to the fund’s securities and/or cash holdings. For this reason, it can be said that banks are more likely to fail than most reputable money market accounts!
Summary: Varieties of Mutual Funds
Stock Funds- Also called equity funds, the assets for these funds are primarily invested through the stock market. They may come in growth or value incarnations, or some combination of the two (“blend” funds).
Bond Funds- Assets for these funds are invested through the bond market. You will see bond funds that focus on short-term, intermediate term, and long-term bonds, or some combination of the three.
Money Market Funds- Consistently priced at $1/share, these funds are really glorified checking accounts with higher interest yields than you would find at most banks.
Hybrid Funds- A combination of two or more types of funds, generally stock funds and/or bond funds. If you understand these other mutual fund classes, then you can grasp the concept of hybrid funds.
Related Work by Earl
1. 'Wall Street Sign'. Source: Ramy Majouji, CC-BY-2.5, via Wikimedia Commons. 2005 Oct 06. Available from: https://commons.wikimedia.org/wiki/File:Wall_Street_Sign.jpg
2. ‘Henry VIII.’ Source: Original Painting by Hans Eworth, Public Domain (i.e., Author has been deceased for more than seventy years: see Article 6.i. under UK Copyright Law.), via Wikimedia Commons. Circa 1520-74?. Derivative art by E.N.B. Original photo available from: http://commons.wikimedia.org/wiki/File:Henry_VIII_Chatsworth.jpg
3. ‘Sign on Wall Street captured as background light creates a shading effect.’ Source: Galaksiafervojo, CC-BY-2.5, via Wikimedia Commons. 2005 Dec 9. Available from: http://commons.wikimedia.org/wiki/File:Wall_St_Sign.JPG
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.